FHA vs. Conventional Mortgage Loan: Weighing Your Options

Nearly every home buyer will reach a point where they must choose between FHA loans and conventional mortgage loans. It's a big decision that should not be taken lightly. In this article, I'll share my own FHA vs. conventional experience with you. We spent a lot of time researching this subject when we bought a house in 2011. So you can benefit from the knowledge we gained.

Our Home-Buying Story

In the spring of 2011, my wife and I bought a home in San Diego. It was our third time buying a house, so we were pretty familiar with the different mortgage options. But we had never used an FHA loan before -- only conventional mortgages. This time around, we ended up using an FHA home loan to buy the house. The down payment was the biggest draw for us. We spoke to several mortgage folks about the pros and cons of conventional versus FHA loans. Here's what we learned along the way:

The FHA Home Loan

An FHA loan is simply a mortgage loan that gets insured by the Federal Housing Administration, which is part of HUD. As a borrower, you would apply for one of these loans through an FHA-approved mortgage lender. So you have to meet two sets of guidelines -- the FHA's requirements as well as the lender's. The government insurance comes into play if the homeowner defaults (i.e., stops making payments on the loan). In a default situation, the FHA will cover the lender's losses. We will talk more about this insurance later.

The benefits of using an FHA loan include:

1. Smaller down payment.

If you use a conventional mortgage loan (defined below), you'll probably have to put at least 10% down. Some lenders are still willing to allow down payments as small as 5%. But with an FHA home loan, you could put down as little as 3.5% of the purchase price. The only way to put down less is by using the VA or USDA loan programs, but those are limited to certain types of borrowers.

This was a big attraction for us when we bought a home in San Diego. We actually saved up enough money to make a larger down payment. But a 10% down payment would have seriously limited our buying power. So we ended up choosing the FHA program to reduce our down-payment expense. This is a common strategy for first-time buyers in particular, because they often lack the money needed for larger down payments. When we were choosing between FHA and conventional mortgage loans, the down payment was the biggest factor.

2. Easier approval than conventional loans.

It's generally easier to get approved for an FHA loan, as compared to a conventional mortgage. This is especially true in 2011. If you put down less than 20% on your loan, you'll be required to have private mortgage insurance or PMI. With a conventional mortgage, the insurance comes from a private company -- not from the federal government, as with FHA loans. These insurance providers took huge losses during the foreclosure crisis that began in 2008 (and is still ongoing). As a result, PMI companies are fairly strict about the loans they will approve.

If you were to use a conventional mortgage loan with less than 20% down, you would essentially have to be approved by two different companies. You need to get approved by the lender as well as the PMI provider. These insurance providers often require higher credit scores than the lenders themselves. They won't back any loans if there is the slightest amount of risk from the borrower.

So if your credit score is below 700 or so, you might have trouble getting a green light from the PMI company. When this happens, it doesn't matter what the lender says. You can be approved by the lender but denied by the mortgage insurance provider.

But with an FHA home loan, the mortgage insurance comes from the federal government. And they are less strict about the types of borrowers they are willing to ensure. In fact, the FHA allows credit scores as low as 500. (Just realize that some lenders will require credit scores of 620 or higher, even though the FHA's guidelines allow a score as low as 500. This is referred to as an overlay.) Still, when you compare conventional mortgages versus FHA loans, the qualification process is almost always easier on the FHA side.

3. More flexible guidelines for credit scores.

I touched on this one above, but I want to expand on it. If you have a credit score below 640, you may have a hard time getting approved for a conventional mortgage loan in 2011. This is the baseline requirement used by the most lenders. But, as we talked about earlier, the PMI company might require an even higher credit score.

This is another benefit of using an FHA loan to buy a house. You can get approved with a lower credit score. The FHA requires a score of 500 or higher for basic qualification. If you want to benefit from the 3.5% down-payment option, you will need a score of 580 or higher. Some lenders have actually lowered their credit requirements to match those set by the FHA.

In 2011, Wells Fargo lowered their minimum score to 500 for some FHA loans. This means that people who would never qualify for a conventional loan could get approved through the FHA program. When you consider that Wells Fargo is the largest mortgage lender in the United States, you can see how significant this is.

Credit scores weren't an issue for us when we bought our home. My wife and I both had credit scores over 750. In this range, we could've qualified for either an FHA loan or a conventional mortgage. But I know a lot of people don't have scores that high. The lower requirement on the FHA side could be a deciding factor for these folks. At any rate, it needed to be mentioned in this discussion.

4. Higher allowance for DTI.

When you apply for a home loan, the lender will review your debt-to-income ratio or DTI. This is a comparison between the amount of money you earn each month, and the amount you pay toward your debts. A higher DTI can hurt your chances of getting approved for a loan. It can also reduce your buying power.

This is another key consideration when looking at FHA loans versus conventional mortgages. With an FHA loan, it's possible to get approved with a debt-to-income ratio higher than 50%. It might not be wise to take on a mortgage loan with that much debt. But it is possible through the FHA program. I know people who have been approved for FHA loans with DTI ratios as high as 58%. This would never work for a conventional mortgage loan. For conventional, the debt-to-income ratio is usually capped at 45%.

The DTI factor wasn't a big issue for us. Our ratio was in the high 30s, so we probably could've been approved for either conventional or FHA. I just wanted to mention it in this section, because it can be a deciding factor for mortgage approval.

As you weigh your options between FHA loans and conventional mortgages, you need to consider the debt factor. And when I talk about "debts" in this context, I am referring to your car payment, credit card debt, student loans, etc. In other words, anything that shows up on your credit reports.

5. More forgiving of bankruptcy and foreclosure.

If you've had a bankruptcy filing or a home foreclosure in the past, you may find it easier to qualify for an FHA loan. Most conventional mortgage loans end up being purchased by either Fannie Mae or Freddie Mac. These organizations have rules regarding borrowers with a foreclosure or bankruptcy on the record. The FHA has rules about this as well, but they are more lenient.

It's possible to qualify for an FHA home loan within one or two years of a bankruptcy or foreclosure. You would probably have to wait a little longer for a conventional mortgage with either of these things in your past. You can learn more about this topic here.

It's Not a Free Pass for Reckless Borrowers

I'd like to point out that the FHA program is not a free pass for irresponsible borrowers. While it's usually easier to qualify for an FHA versus a conventional mortgage, you still need to have your finances in order.

Over the last few years, the Federal Housing Administration has tightened up its lending requirements. They are requiring borrowers to have higher credit scores and larger down payments than in the past.

If you decide to use this mortgage option, you can be sure the lender will review every aspect of your financial situation. They will check your credit score to ensure it meets the FHA's minimum guidelines. They might even impose their own higher guidelines on top of those required by the FHA. They will check your employment history to make sure you've been gainfully employed for the last couple of years. They will consider the amount of debt you have in relation to the amount of money you make. And, of course, there are certain loan limits for the amount of money you can borrow.

I wanted to point all of this out, because there was a notion in the past that anyone could qualify for an FHA loan. But that is simply not the case today.

The Conventional Mortgage Loan

A conventional loan is one that is not insured by a government entity. These loans are made entirely in the private sector, without any government approval whatsoever.

The primary benefit of using a conventional loan is that you can avoid mortgage insurance entirely. If you make a down payment of 20% or more, you won't have to pay for mortgage insurance. But if you put down less than 20%, you'll have to pay for PMI. This would increase the size of your monthly payment by $60 - $90 (on average).

If you can afford a down payment of 20% or more, the conventional versus FHA question is sort of a no-brainer. In this scenario, it would be best to use a conventional mortgage loan so you could avoid the extra insurance cost.

People with smaller down payments have a tougher decision to make. For example, if you can only put 10% down for a conventional loan, you will probably be required to pay for PMI. The question is -- how does this cost compare to the extra mortgage insurance you would pay on an FHA loan? In most cases, the cost of PMI is much less than the insurance you would have to pay for an FHA loan. But then there's the down payment consideration. The FHA program offers a down payment as low as 3.5% for qualified borrowers.

Government vs. Private Mortgage Insurance

It really comes down to insurance costs and down payments. If you can afford to put 20% down on your loan, you'll have an easier time choosing a type of loan. It makes sense to use a conventional mortgage loan in that scenario, because you wouldn't face any type of mortgage insurance at all.

But once you get below the 20% mark, the FHA loan starts to look pretty darn good. With a down payment of less than 20%, you're going to pay mortgage insurance in some form -- whether it comes from the government or from a private insurer. Then it's just becomes a matter of priorities.

What's Your Biggest Priority?

At this point, you have to ask yourself what's more important to you:

Do I want to make the larger down payment of 10% on a conventional loan, and pay a smaller amount of mortgage insurance each month?

Or ... do I want to make a smaller down payment of 3.5% for an FHA loan, and pay more in mortgage insurance every month?

Answer these questions, and you'll know which type of loan is right for you. You can see it's a trade-off either way. This is a question you must answer for yourself. Your lender cannot do it for you.

As for my wife and I, we chose the smaller down payment allowable under the FHA program. This resulted in a slightly higher mortgage payment each month, because the FHA insurance costs are higher than private mortgage insurance. But we increased our buying power by reducing the down payment requirement. In California, it's almost impossible to find a conventional mortgage with a down payment of 5%. Most lenders in the state are requiring at least 10% down. So for us, the difference between 3.5% and 10% was the primary deciding factor.

This article explains the pros and cons of conventional versus FHA home loans. If you would like to learn more about any of the topics discussed in this article, use the search box at the top of this page. You'll find a wealth of information on this site!